The currency has been pegged at Rmb8.28:US$1 in recent years. Devaluation is unlikely unless China's current-account balance moves into a large, sustained deficit. The exchange rate peg has, at least for now, helped to prevent a repeat of the bouts of high inflation China suffered in the 1980s and early 1990s. Price worries have not disappeared though. The risk of inflation has now been replaced by the threat of deflation: consumer prices fell in 1998-99, and again in 2002. In addition to the exchange rate peg--which means adjustments to external shocks must be made through changes in domestic prices--inflation appears to be being held down by domestic over-supply, and related relatively weak GDP growth. Officially the economy is growing by around 8% a year. While impressive internationally, this is much slower than the double-digit growth rates recorded in earlier years; official GDP figures are also widely believed to overstate the true rate of growth by perhaps two percentage points.

ANALYSIS

* A renewed, sharper economic slowdown in the US and other markets depresses GDP growth (Moderate risk).

Exports have grown strongly in 2002. Export growth has been driven as much by increasing market share--the product of China's attractiveness to foreign investors--as growing overseas demand, so China is not as vulnerable to a weakening in global trade as some other countries. But with exports making an ever-larger contribution to GDP, a sharp weakening of external demand would clearly be painful. And there is a risk that external demand will weaken. Serious imbalances remain in the US economy (current-account deficit, high borrowing and rising property prices) that will have to be worked out sooner or later. Other risks include prolonged equity market weakness contributing to a collapse of consumer and business confidence and an economic fall-out from a US invasion of Iraq that does not go according to plan. The Japanese economic recovery seems to be almost entirely driven from without and seems to be petering out already, and growth in the EU will remain slow.

China is suffering from mild consumer price deflation. This has resulted from a fixed exchange rate (which means adjustments to external shocks must be made through changes in domestic prices), soft international oil prices (China is a net oil importer), oversupply in domestic product markets, and lower prices on imported goods as a result of lower tariffs. If deflation takes hold, consumers will again be dissuaded from buying at prices that are clearly going to fall further and domestic demand growth will weaken. Companies producing for the domestic market should exercise caution in planning inventory growth if consumer price indices show successive falls. Companies are cautioned not to put all their eggs in one basket, even if the basket is as big as China. Many consumer goods markets already have highly competitive local incumbents or are oversupplied, and it would be very difficult for a new entrant to make profits there. In other markets incumbents may not be as vulnerable as they seem, particularly where they are politically well connected.

BACKGROUND

Economic Structure

China is in the throes of a twofold industrial revolution. On the one hand, as in industrial revolutions in other countries, there is movement of people from the countryside to the towns. But an industrial revolution is also being encouraged in the countryside. While the majority of the labour force is still classified as rural (500m out of a labour force of almost 750m in April 2002), as many as 150m of these, according to some estimates, have moved to cities in search of higher pay. Millions more who live in the countryside are not employed on the land. An agricultural survey conducted in 1996 found that nearly one-quarter of the rural labour force had taken employment in rural industry or services. Including dependants, the true peasantry now numbers between 480m and 530m. The "non-agricultural village population" included in 1999 about 127m employed in township and village enterprises (TVEs).

The process of industrialising the countryside is encouraged for many reasons: finding non-farm employment for millions in the countryside is vital if the productivity of agriculture is to rise; established urban centres are already lacking in infrastructure; and the existing, already stretched, social control system could not withstand a larger rural-urban migration.

Economic growth has, for many years, been led on the supply side by increases in industrial output. Even before Deng Xiaoping's reforms, the Chinese economy was characterised by industry's unusually large share in gross output value. This was particularly striking because so much of the workforce remained on the land. At first, in the early 1980s, the reforms represented a shift of national resources towards agriculture, through a sharp rise in the procurement price paid for agricultural crops and what amounted to the privatisation of agriculture. However, by the late 1980s, industry's contribution was again increasing as parts of the countryside began to industrialise. Meanwhile, services have also been growing rapidly, as controls on the economy have been reduced and demand for personal services has grown.

Industry has undergone a fundamental shift. Until 1978 output was dominated by large state-owned enterprises (SOEs). Since then, much of the boom in manufacturing output has been produced by "collective" enterprises, under the aegis of local governments, by TVEs or, increasingly, by private entrepreneurs or foreign investors either in wholly-owned enterprises or in joint ventures with Chinese interests. By 2001 the share of the official state sector in industrial output had shrunk to about one-quarter. Nevertheless the state sector tends to contain industries that are the most capital-intensive and often the largest in scale, and financing them absorbs a large share of national resources, especially financial resources.

The coastal areas on China's eastern seaboard have benefited from their accessibility, their links with overseas Chinese and their more developed infrastructure. They have consistently achieved far higher rates of growth than the western provinces. Western China is in many places arid, mountainous or otherwise infertile. The main population centres have always been the wheat-growing plains of northern China and the rice paddies of the Yangtze Delta. The Ninth Five-Year Plan aimed to address the widening inequalities of wealth and income between the coast and the interior by concentrating investment, both domestic and foreign, in the interior provinces, and the Tenth Plan, which began in 2001, is continuing this emphasis.

Economic Policy

Throughout the reform era, the priority of economic policy has been to maintain an overall growth rate high enough to keep unemployment in check and provide improved living standards for the maximum possible number of people, yet not so rapid that it fuels inflation. There has been considerable debate about this rate of growth. A consensus emerged in the late 1990s that an average rate of real GDP growth of around 7-8% per year was sustainable and necessary for China. At the time of Deng's final decisive intervention in 1992 it was thought that this rate could be as high as 10% a year.

In the 1980s and until the late 1990s a major part of the impetus behind rapid growth was the incremental role of economic reforms. The effective dismantling of the rural commune system in the early 1980s, the raising of procurement prices for agricultural commodities and the removal of a panoply of controls and quotas--for example, controls on most prices--were accompanied by the progressive opening of enclaves of economic activity to foreign trade and investment. The result was the unleashing of energies previously suppressed, including an investment hunger that exacerbated existing infrastructure and supply bottlenecks and helped, on several occasions, to fuel economic overheating and inflation.

The reform process remains incomplete. In the mid-1990s it was announced that the goal was to move towards a "socialist market economy", but the precise delineation of such an economy has remained blurred. The "socialist" connotation remains important, as the "state sector" is officially considered to form the backbone of the economy, particularly in the industrial sphere. A hybrid economy seems to be envisaged, one in which ownership of the most important fixed assets, land and natural resources, remains vested in the state, but management, for example in the case of family farms, can be devolved to the private sector. Large and important enterprises, including industrial and financial enterprises of national importance, will continue to be managed and majority-owned by the state, and will be encouraged to merge into nationwide conglomerates, capable of competing on international markets as well. Large chunks of ownership of major state-owned corporations are now being disposed of by massive share flotations, both in China and abroad. Smaller enterprises will be subject to private, collective and other hybrid ownership structures, including foreign ownership.

In place of the administrative orders, quotas and procurement that characterised the economy in the pre-reform era, market signals now predominate. Most prices have been decontrolled and the participation of foreign investment in more sectors of the economy will be permitted, especially now that China has joined the World Trade Organisation (WTO). The state will withdraw from many of its previous areas of direct control, and will, eventually, encourage the channelling of personal savings into investment by the creation of effective national capital markets. The various forms of ownership currently recognised-state (national), collective (an entity owned by its participants), private and foreign-will be allowed to coexist in various combinations and permutations.

Recent reforms: A brief chronology

1995: A new commercial banking law is adopted, as is a law governing the People's Bank of China (PBC, the central bank); provisional regulations guiding foreign investment; an insurance law; legislation to implement a move to a five-day week; and legislation to regulate the securities and debt markets. Import tariff reductions of 30% for 4,000 of 6,000 lines and the replacement of 179 non-tariff barriers (30% of the total) by tariffs are announced.

A programme of transforming 1,000 state-owned enterprises (SOEs) into fully autonomous corporations is announced. Smaller enterprises are encouraged to merge. The average unweighted tariff falls to less than 23%, with implementation of the reductions from April.

1997-99: Experimentation with different forms of ownership, including joint-stock shareholding, is declared to be compatible with socialism; it becomes clear that the authorities are willing, indeed eager, to countenance the merger, closure or privatisation of thousands of smaller state-owned enterprises while ensuring retention by the state of its majority stake in larger enterprises and its total control of around 500 of the largest enterprises. The government slashes the number of industrial ministries. The average tariff rate on imports is reduced to 17%.

2000-2001: Progress is made in restructuring SOEs. It is reported that the sector made total profits of Rmb241bn (US$29bn) in 2000, up by more than 140% year-on-year. Of the 6,599 large and medium-sized SOEs that had been running at a loss in 1997, 70% had moved into profit, been restructured or merged by end-2000. At the beginning of 2001, the average tariff on imports is further reduced, to 15.3%. In December 2001 China at last joins the WTO.

2002: China begins the process of adapting its institutional and legal system to comply with WTO-related undertakings: tariffs on car imports are cut, and the government announces that in 2003, in order to satisfy the WTO principle of "national treatment", it will unify the 15% preferential tax rate paid by most foreign-invested enterprises and the 33% standard rate for domestic enterprises (officials did not specify what the new rate would be). A new division of corporate taxation revenue between the central government and the provinces is introduced in the 2002 budget.

Many parts of the economy have now slipped the leash of central state control. The government has difficulty in maintaining macroeconomic control when its fiscal and monetary policy levers remain deficient and its formal power to run the economy by administrative fiat has been eroded. The reform period has led to the devolution of economic decision- making powers, including command over resources, from central to provincial authorities, and even more to sub-provincial, government entities.

The progress of reform has rendered fiscal and monetary policy instruments more effective tools of macroeconomic management. Since 1997 they have been used to stimulate the economy. The effects of the 1997-98 Asian economic crisis on export demand, combined with sluggish domestic consumer spending, threatened to reduce economic growth below the rate considered compatible with continued social stability. As a result, demand-boosting measures were introduced from mid-1997. Interest rates were reduced seven times between May 1996 and June 1999.

In November 1999, in a further bid to stimulate consumer spending, a withholding tax on savings deposits was introduced, at a rate of 20%. This move had some impact on the level of private savings, and also on retail demand. In addition, from 1997 there has been a large investment and infrastructure spending programme, valued at around Rmb750bn (US$90bn) in 1997-2000--including central and local government spending, SOE investment and loans--that has been stimulating investment and increasing the spending and borrowing of the central government. During 2000 the government helped to stimulate an acceleration in retail spending by extending two national holidays into week-long holidays during which consumers were enjoined to engage in internal tourism and shopping, and this practice was continued in 2001.

In part, the rising budget deficit has been the product of the reforms themselves--the growing expense of subsidising both urban consumer prices and loss-making SOEs--as well as an inadequate tax take. There has also been a continuing debate about the division of tax revenue between Beijing and provincial and lower-level governments. In 1994 a reform of the tax system was undertaken, designed both to redress what was seen as an imbalance in favour of provincial governments and to clarify and simplify a system of bewildering complexity. From that year the central government pledged that it would cease to monetise its deficit by borrowing from the People's Bank of China (PBC, the central bank).

Revenue rose more sharply than expenditure in 1994-96, reducing the growth of the deficit. However, the true public-sector deficit is much higher than the 2.7% of GDP that the 2000 figures imply: borrowing is treated in the government's finances as revenue; many of the public sector's financial obligations, for example, military expenditure, are not fully recorded in the budget. The deficit also does not take account of the high and rising cost of lending through the banking system to loss-making SOEs.

The World Bank argues that more accurate representation of government activities is provided by the consolidated government deficit. This consists of the fiscal (budget) deficit plus that part of PBC lending to the financial system that finances the government-directed expenditure of the SOEs. Calculated in this way, the consolidated annual government deficit is estimated to be 5-6% of GDP. Since 1997, when it started pump- priming in earnest in order to support growth, the government has raised large amounts in bonds from the public and this has focused attention on the sustainability of the Chinese fiscal position. The national debt stood at Rmb1.6trn in the first quarter of 2002, about 16.3% of GDP. But foreign debt of US$149bn at end-2002 and the so-called hidden debt of US$50bn raise total government liabilities considerably. To this must be added pension liabilities of Rmb3.7trn, and about Rmb108bn in benefits to laid-off workers each year. There is also the question of SOE debt and banks' non-performing loans, which have thus far been recognised as government liabilities.

As noted above, the process of reform of the state-owned sector of the economy is far from complete. Nor is it proceeding at a regular pace. In early 1997, before the Asian crisis and while domestic demand was still growing strongly, the vice-premier, Zhu Rongji, set 2000 as the deadline for the substantial completion of the restructuring, by closure, merger or sale, of the SOEs. Since many of the 100,000-odd SOEs were losing money, this implied that reform would save the government substantial sums, but would also lead to a sharp increase in unemployment. As growth started to slow, it is not surprising that the authorities, especially in areas where large-scale, loss-making industry predominates, have been less than enthusiastic about seeing through these industrial reforms. The process gathered considerable momentum in 1999-2000, with several sectors, including coal mining, textiles and steel, facing restructuring and capacity reduction. In 2001, with the authorities again concerned about a possible economic slowdown and worried by popular opposition to SOE reform, there were signs of soft-pedalling on reform in certain sectors.

Because they have traditionally channelled investment into the state-owned industrial sector, the state banks are burdened with large amounts of non-performing debt. China's state-owned banking system is weighed down by a non-performing loan (NPL) ratio officially put at 30%, but which outside estimates suggest could be as high as 50%. Most banks are probably insolvent when judged by internationally accepted accounting standards (although newer institutions have sounder balance sheets and have been subject to less political intervention in their lending practices). The banks have been allowed to build up such large stocks of bad debt by the high propensity of Chinese citizens to save. The banks cannot, however, rely on consumers to keep saving. The poor condition of the state banks' balance sheets also restricts their ability to support economic growth. The authorities have therefore been attempting to resolve the bad loan problem by establishing asset management companies to take on the non-performing loans held by the main state banks.

One of the problems facing investors in China is the high degree of uncertainty and confusion that still surrounds the legal status of economic entities and transactions between them. As part of the process of bolstering the rule of law, a raft of legislation covering matters such as land ownership, contract and securities has been prepared in recent years, and more is on the way. But there is still much more to be done, in the field of legislation and even more in the recruitment and training of a professional legal cadre.

One of the reasons why it is so difficult to tackle the issue of SOE reform is that welfare benefits--such as education, housing, healthcare, and even pensions-have traditionally been the responsibility of enterprises. This has contributed to a rigid labour market and has burdened enterprises with large fixed costs. These welfare functions are now being divested. Some are being hived off into separate service companies, and others are being assumed by the state, which generally means local government. This is an onerous burden, especially in the old industrial rustbelt areas of the north-east, where the economy is dominated by SOEs. Pension and health insurance schemes, financed by payroll deductions, are also gradually being established.

China has been remarkably successful in attracting foreign investment. By the early 1990s it was the largest recipient of foreign direct investment (FDI) in the developing world. At first, a cordon sanitaire was erected around foreign investments, with the establishment in 1980 of four special economic zones (SEZs) in the south, offering tax and other incentives. Such privileges were later extended across most of the country. By the 1990s, and especially after Deng's "southern tour" in 1992, localities were competing with each other to offer foreign investors the most attractive terms. Foreign direct investment (FDI), which contributes to the economy through the establishment of export enterprises and the absorption of redundant labour, reached record levels in 2001, According to national figures, FDI rose by 15.1% in 2001 to US$46.88bn and in 2002 increased to over US$50bn for the first time. .This was a clear improvement from 2000, when utilised FDI was virtually flat, rising a mere 0.93%. The number of foreign-invested projects approved in 2001 rose by 16% to 26,139, while contracted and utilised FDI rose 10.4% and 14.9% to US$69.2bn and US$46.8bn, respectively.

The largest source of cumulative FDI in 1979-2000 was Hong Kong, providing 48.9% of total foreign direct investment. In more recent years the volume of investment from Hong Kong has included a sizeable but unknown proportion of mainland Chinese money; in order to qualify for tax exemptions and to make it easier to take capital out of the country, a large number of Chinese investors have established Hong Kong shell companies and posed as "foreign investors"--so-called round tripping. Taiwan, providing 7.5% of the cumulative FDI in the period, is in fourth place after the US and Japan, but the actual amount from Taiwan is larger because the restrictions imposed by the Taiwan government mean that most of that investment is also routed through Hong Kong. The share of "foreign" capital in China of overseas Chinese origin is high-higher still if ethnic Chinese investors from the US, Canada, Thailand and Australia are included.

In 1979-2000 the US was the second largest foreign investor with 8.6% of the total, after Hong Kong and just before Japan and Taiwan. These percentages, however, understate the importance of investment by industrialised countries, which tends to be in higher value-added sectors involving a degree of badly needed technology transfer, rather than in the labour-intensive processing and assembly operations favoured by investors from Hong Kong and Taiwan, which have helped to fuel the boom in TVE output along the eastern seaboard.

The government has announced its wish to level the uneven playing field between domestic and foreign investors. One reason for this is a feeling that the economy has matured to the point where special incentives are no longer needed to attract foreign funds, as overseas investors will seek entry into China simply because of the potential of its vast market. There is also a pressing need to improve the government's fiscal position by being able to tax all enterprises at the same rate and a desire to bring an end to "round tripping" of domestic capital through Hong Kong. Although the timing of the change has not been made clear and exceptions will also be granted by the many authorities at lower levels, "national treatment" is already being offered to foreign capital in Shenzhen. This will mean forfeiting tax privileges in exchange for better access to the domestic market.

Special incentives apply for foreign-invested enterprises (FIEs) investing in central and western China, as the government hopes to attract foreign funding and expertise to allow these less developed areas to catch up with the more prosperous eastern provinces.

Measures passed by the State Council on October 26th 2000 and published in early 2001, for example, extended until 2010 a 15% enterprise income tax rate for FIEs in "encouraged" industries operating in China's western regions (Chongqing, Gansu, Guangxi Zhuang, Guizhou, Inner Mongolia, Ningxia, Qinghai, Shaanxi, Sichuan, Tibet, Xinjiang and Yunnan). The same State Council measures said that particular emphasis would be placed on attracting foreign capital to industries like farming, energy and environmental industries, and that investments in telecommunications, tourism and banking would also be welcomed. Under the measures, the maximum share of foreign investment in FIEs may sometimes be raised. A notice published by the State Administration of Taxation, effective January 1st 2002 and applying to the 12 above-mentioned geographical regions, introduced special incentives for FIEs investing in postal services, power, radio and television, transportation or water resources. Provided such investment projects have a scheduled lifespan of more than ten years, they can enjoy a two-year tax holiday, followed by a three-year period of 50% reduction of income taxes.

On December 1st 1996 the Chinese government established the de facto convertibility of the currency under the current account by announcing conformity with the requirements of Article VIII of the IMF. Convertibility under the capital account, which has been the aim of the government, has been put off as a result of the global currency market volatility of 1997 and 1998.

In 1997-98 when many countries' currencies depreciated steeply against the US dollar, China came under conflicting pressures in its currency management. On the one hand, large sections of domestic industry, cut off from export markets and threatened at home by inflows of cheap imports, pressed for an early devaluation of the Chinese currency to restore the comparative competitiveness of exports. On the other hand, there was a fear that devaluation would worsen the debt-servicing burden of many enterprises that had assumed foreign-currency obligations and did not enjoy foreign-exchange revenue streams. There was also a perceived need to protect, as far as possible, China's good name and comparatively high credit rating. As time went on the commitment to stability became an article of national pride and, as such, currency policy became a matter of politics rather than economics. The global economic slowdown in 2001 put pressure on the renminbi once more.

Like other developing countries, China has used tariffs and taxes and non- tariff barriers on imports--and, to a lesser extent, on exports--as a policy tool. Non-tariff barriers include controls, canalisation, the trade plan, and the export and import licensing system. Tariffs are not an important source of government revenue. In the early 1990s China's average tariff rate was among the world's highest: its weighted average most favoured nation (MFN) tariff was 30.6% in 1991-93. Under the reductions that were announced at the 1995 meeting of the Asia-Pacific Economic Co- operation forum (APEC), the trade-weighted average tariff fell from 28.1% to 19.8%. It has since been reduced on several occasions, most recently to 15.3% in January 2001. The variability of the tariff regime is also being reduced, although effective rates of protection in manufacturing are high and variable, and protection will remain high in heavy industry. Non- tariff barriers, meanwhile, are extensive.

In recent years progressive measures have been made to liberalise, simplify and streamline China's trade regime. A foreign trade law was promulgated in 1994, but couched in vague terms. During 1995 a number of enabling regulations designed to bolster China's application to join the WTO were announced, including cuts in tariffs. The mandatory plan for exports has been eliminated, although the state retains control through canalisation and licensing of a few goods. China's entry into the WTO on December 11th 2001 will lead to a further improvement in the trade regime, with foreign firms being allowed greater access to the domestic market. The government drafted a raft of legislation in 2000-01 to reconcile domestic law with WTO law in advance of WTO entry. Despite the improvements that will follow accession, however, China's trade regime will remain far from perfect. Barriers to trade at the local level, in particular, are likely to remain significant.

Highlights of the Sino-US and Sino-EU Agreements on WTO entry

(Based on published reports of negotiations)

General principles: Import quotas will be removed within five years. National treatment will be afforded to foreign-invested enterprises (FIEs): in some sectors domestic companies will benefit at the expense of FIEs. Export subsidies will be phased out.

Industrial tariffs: Industrial import tariffs will fall from an average of 24.6% in 1997 to 9.4% by 2005. Specific upper limits and timescales for tariff reduction will be set for a number of products, including machinery and appliances, cosmetics, footwear, ceramics and glass. Tariffs on information-technology products, which currently average 13.5%, will be removed by 2005. Safeguard tariffs on imports of textiles will remain in place until end-2008, when the WTO Agreement on Textiles and Clothing expires.

Cars: Tariffs on passenger car imports will be cut to 25% by 2006. Non- bank foreign financial institutions will be allowed to provide car financing and there will be liberalisation of importation, distribution, sale, repair and maintenance. Wholly-owned foreign enterprises will be allowed in engine manufacture.

Agricultural products: Agricultural tariffs will fall to 17% by 2004. Domestic subsidies on agricultural products will be capped at 8.5% of production value.

Services: Foreign service companies will have the right to choose a joint- venture partner, rather than have one chosen by the Chinese government; the process of registration will be sped up. Foreign legal firms will be able to advise on, but not practice Chinese law. The mandatory localisation requirement for accountancy will be removed and transparency improved. Consulting, accounting and taxation services will be allowed. Wholly foreign-owned hotels will be permitted within three years. Government resorts will be opened to travel agents.

Telecommunications: Telecoms service corridors will be opened in Beijing, Shanghai and Guangzhou; geographical restrictions on paging, value-added services, and mobile phone services will be phased out within five years. Permitted levels of foreign ownership will be as follows: in value-added and paging services, 49% in year one and 50% in year two; in mobile phone services, 49% within six years.

Insurance: Over two to three years the scope of foreign insurance activities will expand to include corporate-sponsored insurance, health and pensions. Foreign property and casualty firms will have unrestricted access on accession. Licences will be awarded on prudential criteria. Permitted foreign ownership in life insurance will be 50% and non-life wholly-owned subsidiaries will be allowed within two years.

Banking: Full market access (with no restrictions on geography or customers) will come in five years; foreign banks will be able to conduct local-currency business with local enterprises in two years, and with individuals in five years.

Distribution and auxiliary services: Distribution rights in rental and leasing, air courier, freight forwarding and storage will be opened in three to four years. Large retailers' equity shares will no longer be restricted to 50%. Foreign enterprises will be allowed to distribute audio-visual recordings, hold 49% shares in distribution joint ventures and invest in cinemas.

The process of policy formulation and implementation is in a state of flux. While the broad thrust of policy--towards the market--is generally agreed upon, there are twists and turns along this path. Preservation of stability periodically takes priority over reform. The central government is also engaged in a continuing low-level battle with local governments to have its policies implemented in cases where they do not coincide with local interests. In the countryside local officials often abuse their power by extracting illegal fees and levies from an angry peasantry and the central government can do little more than fulminate against such practices. As a consequence, in June 2001 the premier, Zhu Rongji, announced that the plan to rationalise rural revenue collection into a single tax would be delayed.

In reaction to the autarky of the pre-reform era and the devolution of economic power during it, there is a centralising thrust to much economic policymaking and an attempt to redefine and re-impose nationally determined norms on a wide range of activities. The use of fiscal and monetary policy is an example of this thrust, but the central government reported in 1999- 2001 continuing and widespread misappropriation and abuse of funds by local government officials throughout China and appears to be having considerable difficulty in preventing this.

The Tenth Five-Year Plan

The Tenth Five-Year Plan was published in March 2001. Like its predecessor, it focuses on the development of the interior, on raising rural incomes and on reform of the industrial and financial sectors for WTO membership. Few specific goals and targets are set, but overall GDP growth is targeted at 7-8% a year.

The text of the Tenth Five-Year Plan was approved at the annual meeting of the National People's Congress. It contained no surprises, its proposals having been well aired in advance. It contains little by way of specific spending commitments, and is more a statement of objectives; economic development is recognised as paramount, the key to tackling all of China's problems. The priorities are to increase rural incomes, create jobs and enhance the social security system.

Outstanding challenges acknowledged by the plan include irrational industrial structures, unco-ordinated regional development, the low level of urbanisation, problems of quality, and weak competitiveness in world markets. It referred to "relatively backward scientific, technological and educational development" and a shortage of skilled personnel. It cited shortages of water, petroleum and other important natural resources, and environmental degradation. There are "institutional problems", obstructing the development of productivity, caused by "the imperfect socialist economic system". Other issues include: "pressure from the population, acute job problems, slow growth in peasant incomes and widening income gaps"; chaotic "market economic order" in some sectors; "corruption, extravagance, wastefulness, formalism, and bureaucratic attitudes"; and "poor public order in certain localities".

Specific targets: The plan envisages the following: GDP growth of 7% a year, taking GDP in 2005 to Rmb12.5trn (US$1.5trn) in 2000 prices and GDP per head to Rmb9,400 (US$1,135); the creation of 40m jobs for urban workers and 40m for workers moving from agriculture; urban unemployment at 5%; annual growth of 5% a year in urban disposable income per head and rural net income per head; and the maintenance of price stability. In 2005 the primary sector should account for 13% of GDP and 44% of employment; the secondary for 51% of GDP and 23% of employment; and the tertiary for 36% of GDP and 33% of employment. Other goals include raising the educational enrolment rate; holding natural population growth to 0.9% a year, to keep the population below 1.33bn; containing ecological deterioration, with the discharge of main pollutants to be 10% below the 2000 level; and expanding the coverage of wooded areas.

Economic structure: Agriculture is "the foundation of the national economy"; at least 129m ha of land should be devoted to arable crops. In 2005 animal husbandry should account for 33% of agricultural output. Land holding patterns and contracts will be stabilised, and the grain distribution system liberalised. The rural tax and fee collection system will be reformed and rural bureaucracy reduced. In industry, market listing, mergers, alliances, and reorganisation will be used to create "a group of large companies and corporate groups with well known brand names and independent intellectual property rights that are outstanding in their main lines of business and have strong core competencies". Factories and mines that produce poor quality products, waste resources, or are serious polluters will be closed. Huge infrastructure programmes will focus on inner China, such as the Tibet rail link.

Economic reform: The "socialist market economic system" will be reformed to "complete the establishment of a modern enterprise system with clearly established ownership, well defined power and responsibility, and separation of enterprise management from government administration", but where "public ownership plays a dominant role." Reform of the financial system will continue. Government organisations will be continuously reformed and streamlined. National treatment will gradually be given to foreign-funded enterprises.

Economic Performance

China's striking recorded rates of real economic growth have been led on the supply side by huge increases in industrial production, and on the demand side by a combination of rapid growth in personal consumption and consistently high rates of fixed investment. This investment has been made possible by the high rate of domestic savings that have been placed largely with the formal banking sector and used to keep state-owned industry afloat. However, the statistics should be treated with some caution. The Chinese media themselves have carried official complaints about the inaccuracy of the data that make up the national growth figures. In particular, local officials and executives have been accused of inflating production figures to curry favour with their superiors. It is also unclear whether the value figures produced as evidence of "real" growth have been deflated in a rational or consistent way to take account of inflation. That a growth rate of 7.8% achieved in 1998 was regarded as tantamount to recession and that vigorous pump-priming has continued ever since is another sign that the industrial output-led GDP data may be misleading.

The boom of the early 1990s was fuelled by huge increases in investment, much of it destined for property development and manufacturing industry. The boom in this sense differed from the two earlier peaks in China's economic cycle that occurred since the reforms were launched in 1978. Those surges in output had been led on the demand side by increases in consumption following the austerity of the 1970s, and by rapid rises in rural disposable income.

As it became clear in mid-1993 that the economy was in danger of seriously overheating, the rate of investment growth became a prime target of government concern. The problem was exacerbated by the availability to the localities of diverse sources of funds. Senior officials in Guangdong province, for example, noted that central government austerity had little effect on them, since they raised about one-third of their funds from their local tax base, one-third from the local banking system and one- third from abroad.

In the 1990s the government sought to break out of a "boom-bust" cycle--periods of rapid growth accompanied by rising inflationary pressures followed by sharp slowdowns in periods of retrenchment. The Eighth Five-Year Plan, produced in 1991, estimated the sustainable annual growth rate at around 6%. Any faster, it was argued, and the shortcomings of infrastructure development and that of basic industries, such as agriculture and energy, would lead to intolerable inflationary and social tensions. However, this strategy was abandoned in 1992 by the then paramount leader, Deng Xiaoping. Double-digit growth came to be seen as sustainable, desirable and even essential in order to create the opportunities that China's massive population was coming to expect. Once again, however, when overheating became a serious problem in 1993-95 ,the authorities decided that sustainable growth would be in single digits, this time around 8-9%. The recent slower rates of growth are attributable in part to the external shocks that have affected China in recent years-- the Asian downturn in 1998 and the slowdown in the US in 2001. However, it also seems that the economy is being held back by the continued inefficiency of the state-owned sectors of the economy, and the close connection between SOEs and state-owned banks, which limits the access that the private sector has to investment funds. GDP growth in China is unlikely to pick up strongly until these sectors are thoroughly overhauled.

Inflation

Rapid growth, until 1996-97, led to high rates of inflation, although the retail price index has tended to understate the extent of inflation in urban areas, where it is most felt among civil servants and others on fixed salaries. In 1994 national retail price inflation was nearly 22% per year, a rate previously seen only briefly in 1988, when it helped to provoke panic buying and hoarding. Austerity measures, mainly administrative, aimed at cooling down the economy were applied in mid-1993 but have been relaxed since 1996, when interest rates and reserve requirements were adjusted to give relief to state-owned enterprises (SOEs) and banks. Inflation was reduced to single-digit rates in 1996, and the fairly sharp slowdown in domestic demand growth that has been in evidence since mid-1997 contributed to falling consumer prices in 1998-99 and a minimal rise in 2000 and 2001. The government now fears a deflationary spiral and is seeking to boost growth and to discourage saving.

From mid-1993 efforts were made to slow the pace of growth, especially of investment, by means of a tight credit policy, supplemented by the imposition of price controls on food in the cities and towns. This, and an increased reluctance by banks to fund the working capital and investment of SOEs unable to meet their debts, put GDP growth on a long-term trend of decline, producing an annual average rate of 7.7% in 1997-2001 after 12% in 1991-95.

The government realises that radical reform of the SOE and financial sectors is required to keep growth within the targeted 7-8% range in the Tenth Five Year Plan period (2001-05). In the short term, slowing or halting the rationalisation of the SOEs and the banks will boost growth by keeping employment levels up and supporting industrial output growth, even if some SOEs are producing for the stockpile. In the long run the diversion of scarce resources to such ends will constrain the growth of total factor productivity.

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